Monday, January 23, 2012

2009 all over again?

I am convinced that the global economy - ever since the financial crisis started in 2007 and put in motion a deleveraging wave - is going through a multi-year cycle which looks in general like this: Weak growth --> low inflation --> Liquidity glut (emanating from the central banks in the deleveraging economies) --> higher prices for financial assets --> macro-economic stabilisation --> higher commodity prices --> higher inflation -->tighter monetary policy --> lower prices for financial assets --> lower growth --> low inflation.
2010 was the year where financial asset prices imploded and growth/inflation weakened but I think that we are now again in an environment where the liquidity glut intensifies (mainly due to the ECB's 3y LTRO) which leads to a longer-lasting rebound in prices for equities, (risky) bonds as well as commodities.

The financial crisis (especially following the Lehman bankruptcy in 2008) pressured prices for financial and real assets sharply lower and led to a severe global recession. Inflation fell significantly and in turn global central banks coul,d orchestrate a massive easing wave and liquidity injections. This led a rebound in prices for equities, (risky) bonds and commodities which - coupled with significant fiscal easing steps - helped also the economy to recover. But mainly due to higher commodity prices, this also led to higher inflation rates which was mirrored by a wave of central bank tightening in 2010 and 2011 (mainly in emerging market economies but also in the Eurozone). This in turn weakened growth and - also via a tighter liquidity environment in the Eurozone - intensified the Eurozone sovereign and banking crises. However, as growth weakened substantially and prices for equities, (risky) bonds and commodities fell markedly, inflation started to fall back again, allowing a growing number of central banks to start easing monetary policy. Furthermore, as in late 2008/2009, the central banks at the epicentre of the financial crisis (this time the ECB) injected an unprecedented amount of liquidity into the system.
I have mentioned previously that the ECB's 3y LTROs are leading to a liquidity glut in the Eurozone (see: The Eurozone liquidity glut dated Jan 17) which should put downward pressure on the external value of the Euro and peripheral/credit bond spreads while it strengthens banks' balance sheets. As a sidenote, the ongoing high level of usage of the ECB's deposit facility usage is not a sign of the stress in the banking sector. If the ECB's support measures create excess liquidity then one way or the other it has to find its way back to the ECB (The liquidity does not go away). More important is whether this liquidity is being hoarded by the banks (a sign of stress) or is floating around the system (and drives asset prices higher as this happens). Last year, banks used the ECB's liquidity operations to hoard cash. However, as Draghi has mentioned at the last press conference, now the banks which make heavy usage of the 3y LTRO are not the ones which deposit liquidity at the deposit facility. Hence, the liquidity has started to float around the system and we are in the midst of a liquidity glut environment!
As a result, I am of the opinion that 2012 could well see a (partial) re-run of 2009, the year where financial markets recovered substantially from very depressed levels and growth turned the corner. I expect financial markets to continue pricing out the systemic risk of a Eurozone collapse/wave of sovereign and bank defaults given that the 3y unlimited liquidity provision keeps the banks liquid and increases the incentives to set up carry trades which in turn also keeps the sovereigns liquid. As this happens, the financial sector should outperform (i.e. bank shares should outperform vs. the rest of the market as should bank bonds). In a second phase, the economic prospects should improve (as sentiment data recovers) which should then take cyclicals higher.

In this environment, especially, the valuation of the Eurozone banking sector appears still at too low levels. The chart below shows the price-book ratio of the Stoxx600 Bank index as well as the index itself. The price-book ratio fell to around 0,5 in early 2009 before recovering to approx. 1,2 in late 2009 and trading around 1 until early 2011. Last year it fell again towards 0,5 and is currently around 0,6. In order to justify these levels, the market assumes that banks either have to take significant losses (which lowers the book-equity) or have to raise new equity at values significantly below book-equity. The first appears unlikely in the short term, given that prices for peripheral bonds (where banks hold a significant exposure) have risen substantially over the past weeks. With the liquidity glut significantly reducing the probability of a default wave, it is difficult to see the banks suffering from such big losses which would lower their book equity. Furthermore, the banks had to present how they plan to fulfil the capital requirements as defined by the latest EBA stress tests until last week and further large rounds of external financing - which dilutes existing shareholders - should be limited. Finally, the ECB essentially injects a two-digit billion Euro amount into bank equity over the next three years without diluting existing shareholders. Following the collapse of Lehman Brothers, markets for bank bonds were shut and banks issued bonds with state guarantees. These bonds had a 3-year maturity (and are expiring this year) and carried an average coupon of 3.5%. Adding to that a fee for the state guarantee, the cost of this funding should have amounted to approx. 4%. If we take this 4% as an average funding cost, then a Eur 500bn take-up at the LTRO for 1% would result in a reduction in financing costs (and hence an improvement in the P&L) of EUR45bn over the next 3 years. In turn, I think that the recovery in prices for financial shares (as well as bank bonds) has further to run.

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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